The Role of Interest & Demurrage in The Future of Money

by Greg on September 22, 2010

demurrage In my recent reading I have frequently come across the related notions that currencies can be “designed” and that certain currency designs would eliminate the role of interest. In order to examine the validity of these claims it is important to first distinguish money or currency itself from that which is monetized. Money commonly serves three functions:

Medium of Exchange
Unit of Account
Store of Value

In modern currency regimes the “store of value” function has largely been usurped by other assets. Few people keep their savings in cash or bank accounts, opting instead for investments that have historically produced higher returns. Interest is simply a proxy for the return on these productive investments. Wikipedia tells us:

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money,^[1] or, money earned by deposited funds.^[2]…
Interest is compensation to the lender, for a) risk of principal loss, called credit risk; and b) forgoing other useful investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost.

Interest is the price paid for the use of borrowed money. Money itself does not pay interest…this is money functioning as stored of value, value lent by one party and borrowed by another that can be exchanged for productive assets. The need for borrowing implies scarcity. Therefore we can infer that interest is truly the price paid for accelerated access to scarce resources. Like all prices, an interest rate is a market signal that enables efficient allocation of these scarce resources – in this case resources being allocated through time, between consumption and investment. This analysis implies two preconditions for the existence of interest:

Scarce resources
Varying temporal preferences for consumption

Critically, these preconditions refer not only to the monetary system but to the constituents of the economy itself – its productive capabilities and the psychology of its participants. A monetary regime intended to eliminate interest would have to resolve at least one of these conditions in the economy itself.

One possible system without interest would be a gift economy. In previous posts I have described how productive abundance could diminish the need for transactional exchange. Interest, being a type of transactional exchange, would have no role in an economy where goods and services were given freely, without obligation, in reciprocal exchanges.

An alternative proposal is that we design a “demurrage currency”. Wikipedia notes:

Demurrage is a cost associated with owning or holding currency over a given period of time. It is sometimes referred to as a carrying cost of money. For commodity money such as gold, demurrage is in practice nothing more than the cost of storing and securing the gold.
…
While demurrage is a natural feature of private commodity money it has at various times been deliberately incorporated into currency systems as a disincentive against hoarding of money, as well as to achieve other perceived benefits.

Unfortunately, this proposal only addresses the currency system without resolving the economic conditions that lead to interest. It seeks to “design” currency without reference to the characteristics of the underlying market it must serve as a proxy for. Whereas the gift economy creates compatibility with new types of abundant value creation, demurrage currency emulates a world of scarce resources – becoming more scarce (depreciating) over time. Wikipedia goes on to explain how demurrage is in practice quite similar to inflation:

Like inflation, demurrage reduces the present value of holding a unit of currency, similar to the effect of a negative interest rate on all currency in circulation. Both inflation and demurrage reduce the purchasing power of money held over time, but demurrage does so through fixed, regular fees while inflation does so through expansion of the money supply through the actions of a central monetary authority distributing the new issue of currency

Given that our current monetary system exhibits behavior quite similar to proposed dumurrage currencies, we can speculate as to whether such a system would in fact provide a “disincentive against hoarding money.” What we observe currently is that people do avoid hoarding cash…but instead of circulating that money they transfer (hoard) their savings into investments – assets that serve a productive function and appreciate over time. The net result is that inflation (demurrage) does nothing to discourage the accumulation of wealth, which is presumably the true goal of demurrage proponents.

What does this mean for interest in future monetary systems? Interest will persist so long as scarce resources persist and market participants endeavor to shift their consumption of those resources through time. Interest will diminish in importance to the degree that productive abundance facilitates a shift away from transactional currency altogether.

photo courtesy of paalia

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Alan Rosenblith

An interesting post, but your analysis regarding interest seems a little off to me…

“Interest is the price paid for the use of borrowed money. Money itself does not pay interest…this is money functioning as stored of value, value lent by one party and borrowed by another that can be exchanged for productive assets.”

This statement does not take into account that ALL of our money is LENT into being, with interest as a precondition for its existence. So money does pay interest in a manner of speaking since money itself is nothing more than debt obligations. This process (called fractional reserve banking) leads to there being more debt in the economy as a whole than money to pay for it, and hence the artificial feeling of scarcity. That is why many people focus on eliminating interest in currency design.

That having been said, I think the hyper-focus some folks develop on eliminating interest in currency design is a little misplaced. It seems to prevent some from seeing more contextual issues around how goods and services are produced in the first place.

Anyway, for a detailed description of how money is created and how that pertains to interest, I recommend this film: http://www.themoneyfix.org
(and not just because I directed it… ).

Alan
Bernd Nurnberger

Good points, Greg. I side with Alan on the importance of the money creation and destruction process (yes, there is). From an earlier posterous:

Money is essentially nothing, split into two of equal and opposite size. Credit. Debit.

A story about napkin money to explain sight deposits, and the triple meaning of “credit” that messes things up. A fourth meaning illustrated by this quote:

“@CoCreatr I suspect that capitalism is the worse system of economic activity… except for all the others that have been tried. ”

Credit: @GrahamHill

If it gets confusing, get out a paper (napkin is OK) and make drawings. http://amplify.com/u/600q

Here is light at the end of an economic tunnel-view:

RT @AlanRosenblith MP in England proposes a bill to end fractional reserve banking: http://bit.ly/bwTzDt #sibos
http://twitter.com/matttrichards matttrichards

Per Alan’s comment: “It seems to prevent some from seeing more contextual issues around how goods and services are produced in the first place.”

I think this clip from Doug Rushkoff is particularly illuminating when driving the point home:

http://vimeo.com/5021110

Designing currencies is about reflecting that which you intend to represent. Inflation does depreciate value of the currency, but when interest is attached to its creation, it is merely a ponzi scheme which makes the the debt bearer richer (simply by having the power to loan at interest) than those who are now in debt.

A demurrage system removes the bias towards investing in financial infrastructure and instead pushes the bias back towards investing in physical infrastructure.

“Whereas interest promotes the discounting of future cash flows, demurrage encourages long-term thinking. In present-day accounting, a forest that has the capacity to generate one million dollars a year every year into the foreseeable future is considered more valuable if immediately cut down for a profit of 50 million dollars. (The net present value of the sustainable forest calculated at a discount rate of 5% is only $20 million.) This state of affairs results in the infamously short-sighted behavior of corporations that sacrifice (even their own) long-term well-being for the short-term results of the fiscal quarter. Such behavior is perfectly rational in an interest-based economy, but in a demurrage system, pure self-interest would dictate that the forest be preserved. No longer would greed motivate the robbing of the future for the benefit of the present. The exponential discounting of future cash flows implies the “cashing in” of the entire earth as opposed to an immediate wholesale “liquidation” of our remaining resources.”

Taken from: http://p2pfoundation.net/Demurrage
http://OnTheSpiral.com Gregory Rader

Alan and Bernd,
I appreciate the analysis of the money creation process (and will definitely check out the film) but I think it is important to differentiate the process of money creation from the behavior of the monetary system resulting from market driven behavior. In making this point I will refer again Alan’s own quote:

“…currencies DO NOT create behaviors. Currency designers DO NOT play puppet master to the unsuspecting and largely ignorant masses. Currencies are adopted and adapted because they support existing behaviors. For instance, when we made the shift to fractional reserve banking, the merchant class already needed a form of money less controlled by monarchs to support an emerging industrial production model. The evolution in currency happened because it supported an ascending pattern of economic production.”

A quick glance at the different conceptions of “The Money Supply” clearly demonstrates that money is not one uniform entity with consistent behavior, despite the fact that we often talk about it as if it is. The fact that there are many types of money and many interest rates reinforces Alan’s point – that the monetary system is molding itself to the underlying characteristics of the market. Those characteristics that market participants to demand interest on loans are primarily:

-Preference for current consumption over future consumption
-(Productive) Scarce resources that can be “invested” to increase the supply of resources in the future.

Regardless of the “design” of a currency, market participants will demand interest payment so long as these conditions exist. My purpose therefore is not to argue for the status quo, but to point out the root cause of the status quo. If people seek to change the status quo, their best opportunities are in the areas where these underlying dynamics are changing (scarcity).
Gregory Rader

@MattRichards
A critical point is missed in the examples used by Rushkoff. You state:

“A demurrage system removes the bias towards investing in financial infrastructure and instead pushes the bias back towards investing in physical infrastructure.”

However, the examples used by Rushkoff and others like him all come from societies where financial investments are not available. These are societies where there are only two choices – consumption or saving. In modern society we have a third option – investment…and investment provides a financial return because it uses scarce resources in the present to produce more scarce resources in the future.

Once securitized investment enters the equation the demurrage logic breaks down. A market participant who previously had to choose between consumption or depreciating savings, now chooses between consumption, depreciating savings or appreciating investments. This choice simply shifts hoarding in currency to hoarding in investment products. This is exactly what we experience today, inflation (depreciating currency) does not lead to accelerating consumption; instead it leads to investment in inflation protected assets.

The example noted in your quote would need to make reference to the underlying market dynamics in order to convincingly make the point it intends. Why is the interest rate 5%? Why is the current profit $50m while the sustainable yearly profit is only $1m? What are the underlying supply and demand dynamics? These variables cannot be assumed without reference to causes.
AlanRosenblith

Greg,
Excellent distinction around currency design versus behaviors derived from the market! I see the relationship between economic practices (like expecting an ROI for taking a perceived risk) and currency design as a continuous feedback loop. The market gives us an incentive to care about certain flows, so we mark those flows (like ROI or a credit rating). But the market’s behaviors are to a large extent determined by how we mark economic to begin with (a.k.a. money w embedded interest).

The quote you cited was mostly directed at currency designers who, upon figuring this out, become a little giddy with power. They see the enormous potential of marking flows differently to affect market behaviors, and assume that is the keystone in creating a new economy. My point was that if you are looking to create a new economy, it might be more effective to find places where people are already engaging in the behavior you wish to promote, and help them do it better by creating currencies that better serve their needs. For me, the most interesting example is in commons-based peer-production since most of the underlying behaviors are outside the market, and therefore would be supported by currencies not based on the quid-pro-quo agreement.

Great discussion, btw!
http://twitter.com/matttrichards matttrichards

Greg,
The example Charles uses regarding interest comes from modern day society. In his reference savings and financial investment are one and the same. The differentiation is:

Investing in physical infrastructure to reap the benefits in over time
vs
Liquidating physical assets immediately and then investing the money (in savings or other financial instruments).

This is where the bias of interest plays in. Supply and demand, interest rate or otherwise are simply the levers that you can adjust once the currency is in circulation to modify it.

Charles goes into more detail in this video (highly recommended):
http://www.ascentofhumanity.com/interview-for-film-money-and-life.php
Bernd Nurnberger

Greg, and all, the quote about demurrage from current wikipedia reflects a swapping of viewpoint between the value of currency you hold vs. the value of currency you do not hold, i.e. invest. Demurrage effects are in practice quite opposite to the effects of interest / inflation, if you look at Net Present Value over time, the main reality check for decisions to invest.

References:
http://www.transaction.net/money/cc/cc02.html Bernard A. Lietaer
http://p2pfoundation.net/Demurrage
http://thefinanser.co.uk/fsclub/2010/02/the-long-now-of-finance-part-three.html
Gregory Rader

@AlanRosenblith

I certainly agree that there are feedback loops and to some extent I was simplifying the argument in order to make it manageable. Taking that in to consideration, we could certainly remove some of the characteristics of the monetary system that reinforce certain behaviors, but removing that reinforcement will not remove the underlying productivity and scarcity dynamics. In retrospect I think I worded my last paragraph very carefully to avoid the appearance of simply defending the status quo:

“Interest will persist so long as scarce resources persist and market participants endeavor to shift their consumption of those resources through time.

“That sums up my point pretty well…we can remove the feedback loops but the characteristics of the underlying market of real goods, services, and productive resources may continue to encourage some participants to seek some form of interest/return regardless of the currency system. I think we are in agreement on this so I won’t beat the point to death any further

You second point reminds me of a great tweet I saw recently, via @skap5:

Don’t go to war w/ current systems. Too many love them & you will lose. Create the future through connected adjacencies. #BIF6
Gregory Rader

@CoCreatr I presume when you say:

“the quote about demurrage from current wikipedia reflects a swapping of viewpoint between the value of currency you hold vs. the value of currency you do not hold, i.e. invest.”

…that you are referring to confusion about where/how the depreciation of the currency is applied. In other words, if a fee is charged to backing assets (gold, grain,etc) while maintaining a consistent amount of currency then the currency is inflated, however if the demurrage fee removes currency from circulation then future returns (the value of the tree in the example from your third link) are essentially inflation adjusted.

Yet, even given that clarification these scenarios assume too many variables to be exogenous to the scenario itself. Referring again to the tree example, consider the statement:

“In other words, you are losing 5% per year by having your money tied up in an illiquid asset because you could have been earning 5% interest on that cash by putting it into other more liquid assets with faster, shorter-term returns.”

This explanation leaves critical variables out of the equation – that money invested in a financial asset is not simply sitting idle and that the interest rate cannot be dictated exogenously. Money deposited in a savings account is enabled to return interest because the bank then loans this money out to other people who use it to invest in productive ventures. The interest rate, assumed to be 5% in the example, is in reality a function of the productivity of these real investments. If the return on the tree is less than the interest rate, that is an indication that other investments are valued more highly by the market.

I don’t see how any currency design can override the characteristics of the real assets and the preferences of the real market participants. If a currency system manipulates nominal variables then market participants will likewise adjust their nominal expectations, but the relative real relationships will remain the same.

If I am missing something critical I hope someone will be able to point me to a detailed example that describes the specific mechanisms of implementation.
Gregory Rader

@matttrichards Quoted from Charles Eisenstein (http://p2pfoundation.net/Demurrage):

“Both interest and demurrage represent a fee for the use of money, but the key difference is that in the former system, the fee accrues to those who already have money, while in the latter system it is levied upon them. Wealth comes with a high maintenance cost, thereby recreating the dynamics that governed hunter-gatherer attitudes toward accumulations of possessions.”

This again assumes that wealth can only be accumulated in one form: money. If that were the case, as it perhaps it was in some of the societies used as examples, then that would be the end of the discussion. However, in modern economies there are, as a matter of fact, assets that gain in value. If $100k in supplies can be used to build a home worth $150k, then a return has been produced on the initial investment.

People who accumulate wealth do so not by hoarding cash under their mattresses, but instead by making these types of productive investments. Therefore, interest does not accrue to money holders, it accrues to investment holders.

Charles goes on to say:
“Whereas security in an interest-based system comes from accumulating money, in a demurrage system it comes from having productive channels through which to direct it – that is, to become a nexus of the flow of wealth and not a point for its accumulation.”

But that is exactly how people accumulate wealth in our current system. Those “productive channels” are businesses and other productive assets and we assign value to them because they are capable of producing more value in the future (they are securitized). There seems to be a point of confusion with regard to what is meant when someone is said to have X dollars. If Bill Gates is said to have $40B that does not mean he has $40B in money and that wealth was not accumulated by hoarding money. It means that he has invested in productive assets that the market values at $40B.

Samb

Isn’t one persons investment, someone else’s loan where interst is tacked on. If that is the case then doesn’t investing your money fit the mold that Eisenstein talks about. If you have money to lend (invest), you are essentially sitting on that money and adding to someone else’s debt. Unless you invest in real estate that is, but then your potential growth depends merely on the rate of inflation, the perceived value of your land and property, which is again only realized when you sell the property, or refinance the property, which in either case creates more debt for someone else, thus perpetuating the system. There is still more debt than actual money.

http://OnTheSpiral.com/ GregoryJRader

“If you have money to lend (invest), you are essentially sitting on that money and adding to someone else’s debt.”

This is only partially correct. Yes, one person’s investment is another person’s debt. However, it is not the case that the lender is “sitting on that money”. Actually, exactly the opposite has occurred. Rather than sitting on the money the lender has loaned the money to the borrower. The lender is sitting on an IOU from the borrower, which the borrower will be able to repay+interest (presumably) because the borrower is investing that money in some productive venture (building something, expanding a business, etc).

Sepp Hasslberger

Interesting discussion and good points made. But let me come back to the method of money creation. It is very much inherent in the interest discussion.

Banks get a promissory note backed by assets, and they give a loan by creating the money on their books. Somewhere between 80 and 90 % of all liquidity is created in this way by commercial banks. Interest is charged on all such loans. Since the reason for loans is scarcity of cash money (which does not bear interest), there is no way for the economy to do without them. Therefore, as loans get paid back, new loans must perforce be given, to avoid that scarcity of money stop economic activity in its tracks.

Thus, with this mechanism alone, the whole economy is held hostage of interest, because it depends for some 90 % of its liquidity on (interest bearing) bank loans. That is a lot of money skimmed right off the top of the economy.

Demurrage money could conceivably turn that situation around. When we imagine demurrage money we must also imagine that there would be a dedicated issuing authority whose function it would be to create sufficient money to go around. Banks would be restricted to loaning out money that had actually been deposited with them. Money would be issued not as debt, but as a spendable asset. There are diverging views as to who gets that asset to spend. Some advocate that money would be credited to government to spend in public works and to pay its workers. Others say the money issued should go to each and every citizen to provide a basic income to be spent into the economy by individuals.

It is in this way demurrage money would have its greatest effect. It would change the basis of the whole money supply an economy needs from debt-based and interest laden bank money to freely distributed means of exchange that must be spent as it is subject to that constant drain of demurrage.

Individual investment and economic activity would continue in a demurrage economy, much as it is happening today. It is the economy as a whole which would be relieved of a heavy burden – that of having to supply, in return for money, a constant and continuing interest payment on 90 % of all money in existence, to the private issuers of money, the banks.

There are some other interesting points of how demurrage money would change economic behavior, but this comment is already too long as it is…
Gregory Rader

Sepp, admittedly my criticism hinges on the unstated premises that:

a) No “dedicated issuing authority” could conceivably be authoritative enough to enforce a demurrage system except to the extent that it comports with the characteristics of the assets that dominate the economy. If your economy is primarily based on agricultural goods that spoil with time (exhibit natural demurrage) then such a system will be feasible. If your economy is primarily composed of ventures that gain in value over time, then demurrage will not be feasible.

b) Any authority powerful enough to universally enforce such a system would be undesirable.

I want to emphasize that the point of my post was not to claim that demurrage is in all cases impossible and/or undesirable. I leave open the possibility that it could work in certain cases. My claim is simply that the primary feature of such a system, that nobody wants to hold the currency and therefore everyone spends it quickly, becomes a liability in any economy broad and free enough to allow alternatives modes of value storage and exchange.

I am curious how you would propose implementing such a system…assuming a competitive market, any alternative currency will have to gain adoption based on the preferences of individual users. In such a context why would anyone want to adopt a currency that loses value over time?

The Role of Interest & Demurrage in The Future of Money

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