Barter economies can teach us something about the free market rate of interest.

This is a shortened version of a paper I just put online.

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Summary of this shortened version (!)

When goods are loaned by one person to another in a barter economy it is physically impossible for the goods to be simultaneously available to both lender and borrower. Plus there is no obvious reason why interest rates should not be at a genuine free market level.

Same goes for money based economies where only state issued money is allowed (i.e. where private banks are not allowed to create / print money). That is, money cannot be simultaneously available to borrower and lender, plus again, there is no obvious reason why interest rates would not be at their genuine free market (i.e. GDP maximising) level.

In contrast, in an economy where privately issued money is allowed, private banks create money by performing a trick which is too good to be true: money is available to two different people at the same time.

To muscle in on the money creation business, private banks have to offer loans at below the free market rate of interest (assisted by the above trick). That is easy for them to do because money creation is basically costless (both for central and private banks).That forces interest rates down to below their free market (i.e. GDP maximising) level. Also the volume of debts rises to above its free market / GDP maximising level. Conclusion: the system that maximises GDP is a “state money only” system.

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Some anthropologists claim that the standard version of barter economies as set out in economics text books never actually existed. But even if those anthropologists are right, the questionable text book type barter economy still has something to teach us about interest rates.

Interest is sometimes charged in barter economies: for example in a desert island barter economy one person lending a fishing rod to another might ask for a few fish is a reward for the loan. Those fish probably equal interest (though the rod owner might just aim for enough fish to compensate for wear and tear on the rod while it is loaned out). Alternatively, the lender might require no “fish interest” just as in money based economies loans are sometimes granted at a zero rate of interest (e.g. between family members).

Next, while interest rates are doubtless calculated in a more haphazard way in barter economies than money based economies, there is no obvious reason to think interest rates would not, at least in principle, be at their free market level. That is, there is no reason to think interest rates would be artificially high or low. And that’s important because it is generally accepted in economics that GDP is maximised where prices are at free market levels, unless there is good reason to think otherwise, i.e. unless there is what economists call “market failure”.

And since there is no obvious reason to suspect market failure when it comes to loans made in barter economies, the conclusion is that a genuine free market rate of interest will obtain in those economies, and that that will maximise GDP, given that we are considering a barter rather than a money based economy

Note also that in barter economies, lenders lose access to whatever they have loaned (e.g. fishing rods) as long as the borrower has possession of the loaned item.


Money based economies.

As to money based economies, the money based economy that most closely resembles a barter economy is one where there is only state issued money (base money). That is, private banks are not allowed to create money. The reason stems from the way private banks (henceforth just “banks”) create money, which is thus. Where $X is deposited at a bank and the bank lends that money on while telling the depositors they still have access to their money, then the borrowers have access to $X as do the depositors! $X has been turned into $2X. Magic! But that conflicts with what happens in a barter economy, namely that where something is loaned out, the lender no longer has the use of it.

In a state money only system, as with barter economies, there is no obvious reason why interest rates would not settle down to some sort of genuine free market level: i.e. there is no obvious reason why interest rates would be artificially high or low.

The fact that lenders lose access to their money while it is loaned out  might seem a problem in that it might seem people wanting their money loaned out would have to tie up their money for decades on end where that money was loaned to mortgagors. In fact for every person who had let their money be loaned out and then wanted it back, chances are that fairly soon, someone else would want their money loaned out. Thus the latter can replace the former, and while those wanting their money loaned out would certainly not be guaranteed instant access to their money, they would not, at the other extreme, not have to wait years for it.

Also, a system where depositors cannot have access to their money as long as it is loaned out is a system where there is no maturity transformation. And that might seem to be a problem, given that maturity transformation is generally seen by economists to be beneficial. In fact maturity transformation is a load of nonsense, as I explained in this article. (Article title: "The Fatal Flaw in Maturity Transformation....").


Privately created money.

In order to muscle in on the money creation business, private banks have to make loans at below the rate of interest that prevails in a state money only system, the free market rate. But doesn’t making a loan, or indeed making and selling anything else at below the market price involves making a loss? So how do private banks do it?

Well it’s easy: creating the above mentioned extra $X costs private banks nothing essentially! All they do is open accounts for borrowers and credit $X to those accounts. The money comes from thin air.

As Joseph Huber put it in his publication “Creating New Money”, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit.”

As a result, interest rates fall to below their free market rate (which will result in GDP not being maximised), plus the total amount of lending and debt will rise to above its free market level.