Moulton later observed in Financial Organization and the Economic System (1938), that bank credit ("money") had come to be viewed as a commodity in limited supply. (Financial Organization and the Economic System, op. cit., 402.) This was something of a reversal of his previous position from before the Crash of 1929, when he believed that the commercial banking system and the Federal Reserve were operating in accordance with the full definition of money as anything that can be used in settlement of a debt.
This is explained by the fact that Financial Organization and the Economic System is a rewrite of Moulton's earlier work, The Financial Organization of Society. This latter was a college textbook initially published in the 1920s. The last edition was published in 1930 before the New Deal made substantial changes in the economic system, especially in regards to subordinating the central bank to the State and using the central bank to monetize government debt and manipulate the interest rate in an effort to control economic development.
Money as a Commodity
The theory of monetary management to which Moulton took exception consists of a series of ideas that contradict the nature of money and credit. These are, 1) money consists exclusively of coin, currency, demand deposits, and certain time deposits, 2) money in the form of bank credit is a commodity, and 3) "interest" is the price of something in limited supply. This last is our concern in this posting.
When bank credit is regarded as a commodity in limited supply, rather than the amount of credit being something that responds to demand — whatever the level of demand — monetary and fiscal policy change radically, as do prescriptions for economic recovery. In reality, the interest rate for business loans depends not on the quantity of credit (the supply of loanable funds presumed to be generated by cutting consumption), but on the demand for credit determined by the needs of business. (Vide Richard Hildreth, The History of Banks. Boston, Massachusetts: Hilliard, Gray & Company, 1837, 18-19.)
This is because credit for business expands to meet demand, not the other way around. Bank credit is not fixed in quantity, as would be the case if it were based on existing accumulations of savings. Assuming that there is a limited supply of loanable funds not only distorts the whole concept of money as the medium of exchange, it artificially limits the formation and growth of new capital, and inhibits, even in extreme cases prevents economic recovery.
This is self evident from the current condition of the world's economy. We see much-vaunted "recoveries" that focus on "economic growth" in the form of re-inflating artificially pumped up prices of secondary debt and equity on the exchanges. To this we add the vastly increased government spending in a desperate attempt to stimulate consumer demand by inflating the currency, and — of course — the idea that business activity responds to the interest rate charged on the existing supply of loanable funds, not the demand for financing, which the tax system is busily stifling. All of this is based on false assumptions of money and credit, and thus a profound misunderstanding of interest. As Moulton explained,
Many economists and bankers had long held the view that the volume of credit expansion, and hence business conditions, could be readily controlled by means of adjustments of the rate at which business men might borrow. It was argued that recovery from a depression normally occurs as a result of expanding bank credit induced by low interest rates, and that hence recovery might be expedited by means of central bank policy. This theory was derived from a general principle of value, namely, that if the price of any commodity is lowered, other things being equal, the demand for that commodity will be increased. Since bank credit may be regarded as a commodity it would follow that, other things being equal, it its price falls, the demand for credit will expand; hence more credit will enter the channels of circulation, prices will rise, and business activity will be stimulated. (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 402.)Even assuming that the supply of loanable funds is fixed in quantity — as conventional wisdom has it — and even when the vaults of the banks are overflowing with cash, that cash will not be loaned out if there is otherwise no demand for it. No rational man or woman in business will borrow money that he or she doesn't need or does not believe he or she can repay out of the future profits generated by the capital that the borrowing financed.
Nor will a banker lend without adequate collateral. In an economic downturn, the present value of many assets decline in value, especially the securities traditionally used as collateral. Even in the present downturn (a depression in all but name), the wild fluctuations in the stock market insert a degree of volatility into the capital markets that often preclude the use of traditional forms of collateral. In consequence, few businesses will borrow unless subsidized, and few bankers will lend unless protected by a State guarantee (a subsidy or a bailout), whatever the political pressure exerted by the federal government or the Federal Reserve.
The fact of the matter, of course, is that bank credit is not a commodity at all, as Moulton made clear in subsequent discussions: "The third lesson of this period [i.e., the Great Depression] is that open market operations and low interest rates are powerless to create an expansion of credit currency and a rise of prices, in the face of adverse business trends, or beyond 'the requirements of business' as determined by operating conditions at any given period." As Moulton continued,
It will be recalled that open market purchases by the Federal Reserve banks merely result in the transference of funds from the Federal Reserve banks to the member banks, and that the latter cannot put the money into circulation except as business men are interested in borrowing. Even the lowest money market interest rates ever known have not been effective in stimulating appreciable expansion of bank loans. Nor have low rates on long-term investment money succeeded in stimulating expansion in the capital markets. There have been large refunding operations to reap the advantages of lower interest costs; but, as previously noted, the volume of new issues since 1933 has been of negligible proportions. (Ibid., 502.)In other words, the Federal Reserve can lower interest rates all it likes, but it will have no material effect on the rate of new capital formation — on sound and financially feasible new capital formation, anyway. Artificially low interest rates can and do stimulate speculation and government spending, just as artificially high interest rates can stifle growth. The former was the case immediately prior to the 1929 Crash. During the late 1920s, massive amounts of money were being created by commercial banks joined with investment banks for what amounts to gambling on the stock exchange. This problem was corrected in part with the Banking Act of 1933: "Glass-Steagall." With the partial repeal of Glass-Stegall in the early 1980s, the savings and loan debacle was launched, while the stage was set for the current depression with full repeal in the late 1990s.
Raising the rates can derail a recovery — as was, in fact, the case in 1937 — but lowering the rates cannot stimulate a recovery if other conditions are not favorable. While Moulton wrote in response to the New Deal stimulus, the current round of stimulus packages, bailouts, and increased government deficits has had just as little effect in achieving genuine economic growth. The vast amount of so-called growth in the current alleged recovery has come from re-inflating the prices of existing shares on the secondary market, and immense increases in government spending, not new capital formation and consequent job creation.
Economic analysis and policy based on the false premises of a limited supply of loanable funds and the power of artificially manipulated interest rates applied to that presumably limited supply of loanable funds to effect changes in the rates of growth is thus a blind alley. Based on false premises, the conclusions may be true, but are not necessarily true. Until and unless the past savings dogma is proven to be true, then, it makes no sense for the government or the banking system to manipulate interest rates artificially. Further, if interest truly is the price of money, then free market principles mandate that the market itself, not the State, set the rate of interest naturally.
Naturally, these statements will not go unchallenged by economists who adhere to the conventional schools of economics. The first line of defense will, of course, be to declare that we do not understand interest and the role it plays in economic development. In response, we will present the conventional understanding of interest — and then explain why, despite the decades, even centuries of adherence to these outmoded doctrines, the conventional understanding of interest is both misleading and damaging.
The Problem of Interest
Understanding interest can be an intimidating task. There seem to be so many views of the subject that sifting through them to find the truth can seem nearly impossible. Obviously this has the potential to cause massive confusion, if only from the fact that many terms that may seem the same nevertheless have different meanings in different disciplines. The task is to discover the underlying principle common to all aspects of the situation, generalize, and remove any accretions that misunderstanding or interested motives have loaded on to what should be something rather straightforward. Our first task, then, is to discern the basic principles underlying money and credit, and thus interest.
Money and credit — and thus, naturally, interest — are social tools. As social tools or institutions they are based on or derived from human nature itself. Society is (or should be) arranged in a manner to conform as far as possible to human nature. This is all the more important in that the primary end of society is to assist each human person in the lifelong task of acquiring and developing virtue, and thereby fit humanity to its final end, whatever each person may believe that to be.
If money, credit, and interest are not in conformity with essential human nature, they are not filling their proper roles. Instead, they are, in all likelihood, being used to inhibit or even, in extreme cases, prevent people from acquiring and developing virtue, that is, from realizing their full potential as human beings. The first thing we must look at, therefore, is how current understandings of interest go contrary to human nature, and thus, instead of serving humanity, serve only to circumvent, inhibit, or prevent the full development of most people as human beings.
The Modern Concept of Interest
Fact and fiction are so mixed in any discussion on interest that untangling the mess can be very difficult. The task is made a little easier when we keep in mind that neither the quantity of money nor new capital formation is necessarily linked to existing accumulations of savings. We do, however, have to keep that fact firmly in mind at all times.
As commonly construed, interest is the cost of borrowing money. Sometimes interest is understood as a fee paid on borrowed assets — that is, the price of using borrowed money (or the opportunity cost imputed to using one's own money), or money "earned" by funds on deposit.
Already we can see how far this understanding departs from our understanding of money as a symbol of wealth, not the actual wealth itself. As we have already noted, "money" is a derivative of the present value of existing or future marketable goods and services, while "currency" is a derivative of money.
Not being a productive asset, but a symbol of a productive asset or the present value of existing or future marketable goods and services, a charge cannot properly be levied on the use of money as if it were a productive asset or the actual marketable good or service. The use of money — the "usufruct" — is to be spent, that is consumed. Money does not, in and of itself, produce a marketable good or service, nor is it itself a marketable good or service.
The concept of opportunity cost is legitimate, especially when it comes to determining the true, free market determined cost or expected rate of return. On the other hand, money as money does not "earn" anything. Not directly producing a marketable good or service, money is not a productive asset any more than it is a marketable good or service, and therefore cannot be said to earn anything. Presuming that money is productive in and of itself upsets Say's Law of Markets at the most basic level.
Clearly what has happened with respect to money is that many authorities have managed to confuse the thing, with the symbol of the thing. Money can only be said to "earn" something when it is expended on an asset that does, in fact, produce a marketable good or service. If the money is spent on something that does not produce a marketable good or service, the money cannot be said to earn anything.
With respect to the concept of interest as the "rent" of money, that is a little easier to deal with. As we have seen, rent only applies to a charge for the usufruct — the use of a thing — that is not "consumed by its use." Since the "use" of money is to be spent, then money is consumed by its use, and a charge for the use of money cannot properly be called rent.
There is, however, at least one way that rent can legitimately be charged for the use of money. Aquinas gave the example of a man throwing a party (such as a wedding reception), and who wants to make a great display of wealth to his guests. He goes to the local moneylender and borrows a few bags of gold to put on display at the event. At the end of the party, the same gold that was borrowed is returned to the moneylender, who is in justice due rent for allowing his gold to be used as a party decoration, that is, in a way that did not "consume" the gold. The usufruct in that case was the presumed pleasure that the host and the guests derived from looking at the gold, not the usual use of gold as a medium of exchange and store of value.
A Better Understanding of Interest
Other authorities describe interest as compensation paid to a lender, or as being what is due to him or her for forgoing other investments (opportunity cost). This is construed in many schools of economic thought as the price not of money, but of credit. This, too, is close enough to the real case to be extremely confusing, at least until we remember that the distinction between money and credit is, to all intents and purposes, meaningless. Money, whatever its actual form, is itself a credit instrument. It therefore makes no sense to distinguish between the two in this manner.
The distinction between money and credit only makes sense when we restrict our understanding of money to cash, currency, and demand deposits, and on occasion a nod to selected time deposits. Consistent with the "Currency School" understanding of money, we would necessarily have to ignore all other credit instruments, such as notes and bills that, in reality, make up the bulk of the money supply. All money is, in a very real sense, credit, that is, the creation of a debt. The concept of money is necessarily the same as the concept of credit. As Henry Dunning Macleod explained, it is a "fundamental principle we have obtained, — 'Where there is no debt there can be no currency'." (Henry Dunning Macleod, The Theory and Practice of Banking, Vol. II. London: Longmans, Green, and Co., 1906, 253.)
As we might expect, all of the confusion regarding the presumed distinction between money and credit has developed more or less logically from the idea that existing accumulations of savings are the only source of financing for new capital formation. This is not to say that charging interest on existing accumulations of savings is somehow inherently wrong. If it were, the whole institution of private property would be undermined.
No, the problem comes in when we confuse the lawful interest due by natural right to the owner of existing accumulations of savings, and the unjust charges on "pure credit" loans. "Pure credit" is the term for new money created by the extension of private or bank credit, and which does not rely on existing accumulations of savings. New money created by the extension of bank credit is not based on existing accumulations of savings, but on future savings, that is, on income to be generated in the future out of which the loan by means of which the money was created is repaid.
Private Property and Savings
Obviously, the rights of private property must be exercised in different ways when dealing with existing savings, and what is just and proper when dealing with future savings. Compensation to the owner of existing accumulations of savings is the exercise of a right of private property. By contributing his or her "financial capital" an owner of existing accumulations of savings participates in the production of marketable goods and services by providing financing for capital.
Money is not, strictly speaking, true capital. This is because money as money does not, in and of itself, directly produce any marketable good or service. Instead, money can be exchanged for capital that does produce marketable goods and services, or used to settle a debt incurred in obtaining something used in the production of goods and services.
This is one reason why, in accounting, cash in a business is referred to as "working capital." Working capital consists of what the business needs to "work," or carry on the day-to-day transactions that are most conveniently carried out by cash instead of other forms of money. Working capital is classified as an asset (investment), not as savings (owners' equity), although it is an "indirect asset," if we may so describe it, that does not directly produce a good or service.
Since "savings equals investment," as even Keynes acknowledged, clearly "savings" consists of far more than mere accumulations of cash. In accordance with the standard "accounting equation," that is, Assets equal Liabilities plus Owners' Equity, "savings" necessarily equals Assets less Liabilities. More precisely, net investment — total savings, or what the owner owns less what the owner owes — equals Owners' Equity, that is, contributed capital, or what the owners put in, plus income retained in the business — "Retained Earnings."
Here, incidentally, is where Keynes made a fundamental error. This was due in large measure to his misunderstanding of money, credit, private property, and basic accounting theory. He correctly stated that savings equals investment, but then developed his theories as if savings are investment.
On the contrary, "savings" are the amount of an owner's equity — ownership — in the business. Savings may or may not equal total assets, but savings always equals total assets less the owner's liabilities — what he or she owns. Savings are thus a measure of the owner's private property stake in the business, not the assets that are owned.
For example, cash accumulated in a business as working capital or a sinking fund is not savings, that is, a measure of owners' equity. Working capital or a sinking fund are, rather, assets in which the owner has private property. Using cash accumulated in a business to acquire new capital is thus not a use of savings, but a simple exchange of one asset for another; the owner's savings — the measure of what has been accumulated — does not change in the slightest as a result of the transaction.
True, "savings" is often used in popular usage to refer to the cash itself. Similarly, many people refer to what they own as their "property" instead of as their possession in which they have property. In ordinary speech, this makes no difference. It can, however, make all the difference in the world if you're trying to develop an economic theory and you thereby mis-define basic concepts like money, credit, and private property — as Keynes, in fact, did.
The Just Due to Savers
In justice, then, an owner of existing accumulations of savings — more accurately, a measure of his or her ownership stake in a capital enterprise derived from past savings — is due the income generated by the assets that are owned. It is a basic right of private property that an owner is entitled to the "fruits of ownership," that is, the income generated by what is owned.
If an owner used his or her accumulated cash or other investments in which he or she has established a savings property right to finance the formation of the capital, then he or she is due all the income generated by that capital. Similarly, when an owner borrows someone else's accumulation of wealth, he or she in a sense goes into partnership with the lender. The profits of the enterprise in that case are divided between the borrower and the lender on some equitable basis. Because the return to an owner is (obviously) based on his or her ownership interest, the rate of return to the lender of existing accumulations of wealth that compensates the lender for his or her contribution to production is called the "interest rate."
When, however, an owner uses pure credit financing, there is no question of what is due to the non-existent lender of existing accumulations of savings. The project is financed out of future savings, not past savings. Interest is still due, of course, and is due by natural right to the one who provides the savings — but the owner is him- or herself the provider of the savings. He or she is thus not obliged in justice to pay any of the interest to anyone else, but retains all profits as his or her just due.
It is in that sense that we speak of "interest-free money." No interest is due in justice to the "lender" on a loan of money created by extending credit based on the present value of a private property interest in future savings. There may be charges for the costs associated with creating the money and to provide a just profit to the issuer of the money. There is also usually a "risk premium" based on the likelihood that the borrower will default (not repay the loan). These, however, are genuine costs, not a sharing of profits based on an ownership interest.
There is also no question of opportunity cost on a pure credit loan. That is because the money is created for that project alone. Opportunity cost only applies to existing accumulations of savings and the choices made as to their use. When using pure credit there is no "next best alternative" against which to judge the fair return for a project. Because money can be created as needed for financially feasible projects, no choice is made, and thus no compensation is due for foregoing one project in favor of another.
Having gotten a handle on a better understanding of interest, the next question is how best to restructure the financial system to implement pure credit techniques to finance new capital formation. That will be the subject of our next posting.