Where does interest come from?

Economics Economics Questions
1

I am sure this has been discussed before but I couldnt find a recent relevant post or haven’t heard it addressed by an Austrian view.

Where does the money that pays for interest come from? I know there is a ‘value’ to withholding consumption to make capital available but where does the money come from? Take this example:

In a simple economy with 1 bank and 2 people - a farmer and a blacksmith - the farmer borrows 1000 @ 10% interest from a bank and buys tools from the blacksmith with the 1000. Then produces food (with the tools) which he consumes some and sells some to the blacksmith for 1000 (all the money in circulation). The farmer now owes the bank 1100. Where does the 100 from interest come from.

I always assumed the central bank was ever expanding the money supply to make up for this deficit but have never heard it adressed by an Austrian Economist. I always thought the Austrian view was the money supply should/could be fixed but if this were possible everyone would go bankrupt and only few would be left with all the money.

2
3

In a two-agent market like you described there would be no need for money, a bank, or interest. The blacksmith will simply “sell” the farmer the tools in exchange for a note promising part of the food produced.

Z.

4

If I understand you correctly, you don’t see how interest can be paid from an accounting point of view without an increase in the money supply. I think you are referring to the infamous paradox of interest. There is no such paradox. It’s a fallacy invented by inflationists.

First, forget the bank. Loans come from savings. Banks are only intermediaries (suppose to be).

Suppose a capitalist (saver) has $1100. Out of this total, he decides to consume $100 and save $1000. He invests (loans to farmer) the $1000.

The farmer takes the $1000, pays himself a wage, pays wages to his helpers (if he has any), and buys tools. But the tools don’t earn a wage, only the workers who produced the tools. So the money used to buy the tools actually goes to the tool maker and his helpers. In short, all $1000 goes to wages.

For simplicity, we assume that all the members of this community consume only the products of the farmer.

Now, the monetary total for consumption (of the farmers products) is $100 from the capitalist (the portion that he did not save), and $1000 of total wages of the farmer, the tool maker and all the helpers. That’s a total of $1100 in revenue for the farmer.

The farmer pays the capitalist back his $1000 in principle + $100 in interest for a 10% interest. We’re back to where we started. The capitalist has $1100.

There is no interest paradox. No increase in money supply was required.

The capitalist then decides if to repeat the process. This cycle can go on indefinitely until the capitalist decides to stop.

What is still left unanswered for you is this:

How this process works for a more realistic economy

How the process works when the economy grows, or even how it grows.

What happens if the money supply is increased by some agency (government + banks) by issuing more loans then the amount of real savings.

To answer the above, you need Austrian Capital Theory. But I assure you, there is no interest paradox.

5

Borrowers + Banks + Lenders + Everyone Else = “Society”

  1. $0 + $0 + $500 + $500 = $1000

Break society out into the concerned groups

  1. $0 + $500 + $0 + $500 = $1000

<$500@1%<

  1. $500 + $0 + $0 + $500 = $1000

<$500@2%<

  1. $0 + $0 + $0 + $1000 = $1000

Purchase $500 of goods and services from Everyone Else>>

  1. $530 + $0 + $0 + $470 = $1000

<<<<<Sell $530 of goods and services to Everyone Else<<<<<

  1. $20 + $510 + $0 + $470 = $1000

Repay loan $510>

  1. $20 + $5 + $505 + $470 = $1000

Pay Deposits $505>

  1. $20 + $0 + $505 + $475 = $1000

Payroll, Dividends, Expenses 5g>>>>

  1. At the end of the cycle no new money needed to be introduced into the system to pay the interest on the loans and deposits. When the new cycle begins the Borrower and lender groups will be reset because some of the previous borrowers may become lenders and some of the previous lenders may become borrowers.
6

Your mistake seems to be assuming one particular currency is the only thing that can hold value. Money is only a stand-in for other wealth. The value needed to pay back the interest is done through the generation of new wealth somewhere.

Let’s say I borrow $1000 from the bank at 10% interest. I now owe $1100, where does the money come from?

I invest the money into providing some good that someone else is willing to pay $2000 for (thus, they are gaining value, as exchanges are the result of two inequalities, rather than an equality). I use $1100 of that money to pay the bank, and keep the rest for myself.

This also works if there are only two actors, but as someone above me said it doesn’t make much sense to use money at all in that case.

Let’s say I lend you 10 pieces of gold (which happens to be all the gold in existence) at 10%. You provide me with some good that I am willing to give you 5 gold pieces for. Rather than giving you more gold, I just subtract it from what you owe me. You can now give me the 6 you still owe from the 10 you still have, then keep the rest for whatever.

In both cases, new wealth is generated and that is used indirectly to pay the owed interest. The interest is just a mechanism for trading time against other resources, as it is the “price” of having the money now rather than later.

One more point I think I should make, then I’ll shut up: It is certainly NOT the austrian belief that the value of money should be “fixed.” Given our rantings against inflation this is an easy mistake to make, though it is important that you understand the underlying causes. It is perfectly natural (and necessary) for money’s value to fluctuate against the value of other goods, as this is part of a money’s integral function.

Government induced inflation is harmful because it destroys capital by redistributing wealth from those who receive the new currency first from those who receive it later. With “natural” fluctuations in the value of a money, no such destruction happens.

7

It comes from the generation of new wealth somewhere.

Also, it is certainly NOT the Austrian position that the value of a money should remain fixed. A money only has value when compared to other goods. If its value were fixed, that would necessarily mean the value of all other goods must be fixed as well.

The reason why fiat inflation is so harmful is because it destroys capital by redistributing wealth.

8

Sorry for the triple. Damned not-really errors. I like the second post better than the first anyway.

9

Of course not. Austrian Economics is value-free and hence doesn’t recommend anything.

10

In addition to what Southern posted, there’s also this spreadsheet that I think was posted in the forums in the past.

http://spreadsheets.google.com/ccc?key=0Ak0d51fpM-tocDdqU2ZOZWxtN0ZESjQ3ZWsxRHZ4RVE&hl=en

11

When he goes to the bank, he tells the banker:

Here is all the money in existence in our little imaginary world. I still owe you $100.

So we have two choices. I can pay in vegetables.

Or you can print new money, then I sell you $100 worth of vegetables, then give you the $100 back.

In either case, you wind up getting paid in vegetables, because that’s all I have. But in the first case, your money remains as valuable as when we started [if not more so, since there are more goods in the world]. In the second case your paper money and everyone else’s is worth less than before, because there is more paper money in the world [=inflation].

12

I’m not saying you’re wrong, but I have a few questions.

1.) If the capitalist only ever gets $1100 back, what is the point? That’s what he started with so why keep getting the same amount?

2.) What is to stop the capitalist/bank from charging 50% interest? If they did that, would your example still work using the same amount total of $1100?

3.) In your example, you say the farmer pays out $1000 in wages (including tools) but then pays the capitalist back $1000 in principle and $100 in interest. If the farmer paid $1000 in wages, where is the $1000 in principle coming from? Wouldn’t his workers have the $1000 now?

4.) If you’re example is right in that there is no new money created from nothing to pay back the interest, then surely this is not true in our economy today simply by virtue of your final comments “What happens if the money supply is increased by some agency (government + banks) by issuing more loans then the amount of real savings.” If we know the FED prints money from nothing and gives it to banks, which they do, and the bank charges interest on money that came from nothing, then the interest paid back does not exist either, right?

Thanks

13

Here is an example I found online. Can someone tell me what is wrong with it? My guess is it’s too simplified.

Imagine you and I are the only people in the world. Imagine I have the only 10$ available on the whole planet and you want me to lend you them. I would act as the bank creating a loan of 10$ for you, expecting you to return it with an extra interest, let’s say of 1$. Where are you going to get this extra money from, assuming there is no more money on Earth? Once understood this example, extrapolate it to all the money created in the real world. For some people to pay the interests, some others have to go bankrupt as the extra money to pay for the interests does not exist!

14

G. Edward Griffin covers this pretty concisely in his opus The Creature From Jekyll Island (pp. 191-192):

WHO CREATES THE MONEY TO PAY THE INTEREST?
One of the most perplexing questions associated with this proc-
ess is “Where does the money come from to pay the interest?” If you
borrow $10,000 from a bank at 9%, you owe $10,900. But the bank
only manufactures $10,000 for the loan. It would seem, therefore,
that there is no way that you-and all others with similar loans-
can possibly payoff your indebtedness. The amount of money put
into circulation just isn’t enough to cover the total debt, including
interest. This has led some to the conclusion that it is necessary for
you to borrow the $900 for the interest, and that, in turn, leads to still

more interest. The assumption is that, the more we borrow, the more
we have to borrow, and that debt based on fiat money is a never-
ending spiral leading inexorably to more and more debt.
This is a partial truth. It is true that there is not enough money
created to include the interest, but it is a fallacy that the only way to
pay it back is to borrow still more. The assumption fails to take into
account the exchange value of labor. Let us assume that you pay
back your $10,000 loan at the rate of approximately $900 per month
and that about $80 of that represents interest. You realize you are
hard pressed to make your payments so you decide to take on a
part-time job.

The bank, on the other hand, is now making $80 profit
each month on your loan. Since this amount is classified as "inter-
est," it is not extinguished as is the larger portion which is a return
of the loan itself. So this remains as spendable money in the account
of the bank. The decision then is made to have the bank’s floors
waxed once a week. You respond to the ad in the paper and are
hired at $80 per month to do the job. The result is that you earn the
money to pay the interest on your loan, and-this is the point-the
money you receive is the same money which you previously had
paid. As long as you perform labor for the bank each month, the
same dollars go into the bank as interest, then out the revolving
door as your wages, and then back into the bank as loan repayment.
It is not necessary that you work directly for the bank. No matter
where you earn the money, its origin was a bank and its ultimate
destination is a bank.

The loop through which it travels can be large
or small, but the fact remains all interest is paid eventually by
human effort. And the significance of that fact is even more startling
than the assumption that not enough money is created to pay back
the interest. It is that the total of this human effort ultimately is for
the benefit of those who create fiat money. It is a form of modern
serfdom in which the great mass of society works as indentured
servants to a ruling class of financial nobility.

15

  1. Welcome to the forum.

  2. He got $1100 cash plus $100 in food.

  3. The banker cannot determine the interest rate unless the borrower agrees. The borrower will only agree if he thinks he can grow enough food to pay back the loan plus the interest plus have some profits for himself as well.

In any case, if the interest rate is 50%, the farmer will have to wait until everyone is hungry again and buys more food with the money. In the real world the interest is never close to being such a large portion of the money supply.

  1. He gets the $1100 back from the workers when they buy his food.

  2. Not sure what you mean by the interest does not exist.

16

The borrower is only borrowing because he thinks he can use the money to increase production, and also that someone will buy his increased production. In this little world, the only buyer is the banker.

So in that world, the borrower would not borrow the money until the banker agreed in advance to be paid the interest after the principal was paid, and after the banker had time after that to buy another $1 of the borrower’s product.

17

Thanks for the fast reply.

As to #4, if the Federal Reserve has the ability to print money out of nothing (which they do) and lend it to banks (which they do) and the banks then lend it out to people (which they do), then wouldn’t the interest on the loan being paid back come from money that didnt’ exist in the first place? If not, where does that money come from?

I guess my understanding is that because the money was printed and given directly to the banks at little or no interest, then the interest they get from borrowers is not already “built in” to the money supply as in the previous example with the farmer.

18

John,

I think Griffin’s last paragraph misses the boat. Like all voluntary exchange, both sides profit. The borrower gains by having the wherwithal to increase his production. He won’t borrow in the first place unless he estimates he can pay back the loan plus interest plus make a proft on top of all that.

And if we are talking about borrowing to consume, there too the borrower gains by having money right now today to spend, which he obviously prefers to patient waiting.

Not sure what Griffin’s gripe is with the banker making some money too. I guess he isn’t an Austrian, and thus doesn’t know about why interest is paid.

19

No, he knows. I’ll admit that last sentence does seem a bit extreme. But you have to realize we’re talking about a 600 page disection of the Fed…it’s genesis, it’s Congressional history, how it works, what it has done in the past, what it does currently…and everything in between. In that context you realize he’s talking about the total fraud and theft that is taking place due to the practices of a privately owned central bank, that creates money out of thin air, and literally controls the lifeblood of the economy (i.e. the money).

I shouldn’t have to tell you we live under a system of legal tender that is forced into transaction at the point of a gun and can be created and destroyed on the whims of basically one man. And it’s been made quite clear that you better not try to use anything else as a money. If that’s not a form of modern serfdom, I’m not sure what is.

As for her #4, (and really the question I think everyone wonders), it’s this.

“it is technically true that under a FracRB and central banking system[…]it is IMPOSSIBLE for society to pay off all its debt BECAUSE only the principle is created, NOT the interest”…

20

I have found that to understand economics, it helps to look at things from two points of view. The first is to imagine what is going on without money. The second is to then introduce money and see how it affects the picture.

In a world without money, goods are exchanged for goods. A bank would then be a storehouse for goods. When someone asks for a loan, he is asking to borrow some of the banker’s store of tools, so that he can use them to improve his farm land, say. The banker replies that he is willing, on two conditions. First, that he gets his tools back. Second, that he gets a part of the extra food created by the farmland’s increased productivity.

Nothing is really unfair about this. It is almost like buying a share in the land for a while. The only difference is the insistence on the banker’s part that win or lose, he gets his money plus his profit. The justification for this insistence is that the banker has to defer enjoyment and use of his tools [say trading them for cocaine to snort today] until he gets his tools back. Plus of course he is taking a risk, risking a bird in the hand, his existing tools, for two in the bush, because the tools may be ruined or lost etc. by the farmer, never to be returned.

In a world with money, repayment of principal is giving the tools back. Interest payments are giving the banker his cut of the extra food created.

OK, all that was without a Fed that has the right to print money. The Fed printing money is supposed to be giving the bank more tools to give to more farmers to make more land productive. The interest is still the same as before, giving the banks a cut of the extra veggies produced.

What is the problem with printing money then? Not in the interest charged, but in the new money in and of itself.

But that’s a topic for another post.