Politicians use interest rates as levers upon the economy and do much damage to the economy as they do not understand the fundamental link between interest rates and business profitability. Nor do they understand the link between interest rates and prices. The poor are impoverished by high interest rates and the debt trap, as much or more than by low wages. So I propose regulation of borrowing rather than high interest rates, as a better way to control demand.
Some businesses operate on borrowed money, and some on their own capital. But as they are in competition, high interest rates on commercial loans, leading to higher repayments, increase prices across the board. And the longer it takes between borrowing money and production of saleable product, the worse the situation for those on high interest rates.
In the final analysis there are several ingredients in the price of goods:
The higher the proportion of wages in the overall costs, the higher will be real wages. This means the lower commercial interest rates, the higher real wages. (It also means the lower commercial real estate, the higher real wages; a factor which should be taken account of in zoning abundant land for business.)
The equation linking the above factors is:
Price = (wages + asset costs) * (1 + I + P)Y
where
I = Interest Rate (Real)
P = Profit Rate after paying interest
Y = Years between investment and return
The equation above is averaged over all inputs. Even the cost of raw materials bought to produce the product can in the final analysis be pided into wages and asset costs. For simplicity I have neglected taxation.
The deleterious effect of high interest rates for long term investment is readily apparent from the equation. If there are ten years between investment and return, a real interest rate of 7% will double prices before a profit is even begun to be made. Too high an interest rate will make long term investment unviable.
Another factor I have neglected in the above equation is risk. If a business venture has a 50% chance of total failure, prices could justifiably be doubled. And if there was no security, the bank could justifiably ask for the loan to be repaid in double plus interest. Replacing the need for equity with higher repayments, could open up new investment opportunities.
A problem with interest rates is that they are affected by inflation and government monetary policy. It is beyond me how intelligent people can expect to achieve the stability necessary for business to plan and survive, when it does not know from one month to the next what the interest rate will be. The answer is so simple: The banks should have an invariable real interest rate over the term of a business loan, and if inflation devalues money, increase the future repayments by the same amount.
Invariability of interest rates for a given loan would provide a better basis for true competition among banks, as the banks would no longer be able to increase interest rates to existing clients. This would put a dampener on interest rates and keep them to the levels sustainable by the market.
The government should not tamper with real interest rates. They should only adjust absolute interest rates to allow for a change in the level of inflation. An increase in real interest rates can send a business bankrupt unless it can increase prices.
As high interest rates increase prices and cause financial hardship to the poor, it would seem better to reduce personal borrowing by regulation rather than by high interest rates. Perhaps borrowing could be limited to a certain multiple of salary, on someone’s first home loan, and less than this on a second home loan. This would allow interest rates to be kept low on personal loans.
To allow women to be financially able to have children when they are young, the loan could be set at a certain multiple of (husband’s salary plus half wife’s salary). This would prevent wives being forced to work full time until they are middle aged, just to secure a sufficient loan to bid against others who are doing the same. That people would not be able to borrow so much would be to their benefit, as it would cause house prices to fall.
At the moment the high interest rates on home loans goes three ways: to the lender who saves with the bank; to the bank; and to the government in tax. In times of high inflation, because the government taxes total interest rather than real interest rates, the lender earns very little and may even make a loss, whilst the government makes a windfall. That government revenues depend upon the level of inflation creates much uncertainty in economic planning.
Obviously the present situation is unsatisfactory. The government, by taking a large proportion of the interest, is in effect taxing those least able to pay. And the banks, by presiding over a large difference in their borrowing and lending rates, add nothing to the economy, and are in effect parasitic middle men.
The solution is government regulated low interest rates, with lower effective tax rates and lower bank margins. For low value loans up to the median house price the borrower would pay 2.5% real interest, with 1.5% going to the lender, 0.5% going to the bank for administration and insurance, and 0.5% going to the government in tax. No other tax should be levied on the lender or bank. People should not be allowed to walk out on their loan if the house price falls below the amount still owing, as this would be unfair to the bank.
For loans between median house price and three times median house price, on that part of the loan above median house price, the borrower would pay 3.5% real interest, with 2% going to the lender, 0.5% going to the bank and 1% going to the government in tax. There is less justification to help those above average income. Nevertheless some help may be appreciated, as usually the greatest financial need is when buying a home and raising a family. Even rich people may prefer to pay higher taxes at other times, in order to be helped at this time.
On loans above three times median house price, that part of the loan exceeding this, the borrower would pay 5% real interest initially, with 2.5% going to the lender, 1% going to the bank, and 1.5% going to the government in tax. The banks carry a greater risk for more expensive houses as they are more subject to price fluctuations, and as there is greater earning uncertainty for many high income earners. When a ceratian proportion of the loan is payed off, perhaps a third, the bank’s margin could be reduced to 0.5%, as with other loans, giving a total rate of 4.5% real interest.
With all these loans, an additional amount must be added to the repayments, to allow for the erosion in the value of money due to inflation.
I think that the maximum term of a loan should be twenty years, but if the borrower falls into financial difficulty through no fault of their own, such as through sickness or loss of employment, the term should be able to be increased by up to five years. In the early stages of loan repayment, especially if the loan was for the full price of the house, it may not be practical to extend the term of the loan so much. But in this case there is less hardship to lose a house one has only lived in for a year or two. An ombudsman is needed to adjudicate between the bank and the borrower. Interest should not accumulate when one temporarily cannot meet repayments through sickness or unemployment. But even with these provisions, it would be necessary sometimes to move to a cheaper home. But in these cases, the occupants should be allowed to stay in the home paying rent until they find somewhere suitable.
Until a more reasonable home loan interest scheme is adopted, I would like to make some comments to improve existing practices. As with commercial loans, fixed interest home loans should not be allowed, as this is a gamble. If inflation increases, the bank loses; if inflation decreases, the borrower loses. It is utterly stupid to allow a situation to develop where either the banks or large numbers of home owners could be thrown into financial ruin, simply by a change in the level of inflation. What the banks should offer borrowers is fixed real interest rates, whereby the borrower will pay, in real terms, the same amount irrespective of any fluctuations in inflation or government monetary policy. This puts no risk on the borrowers and much less risk on the banks.
Whatever the government does, it should avoid the Japanese trend to hundred year loans. This would result in an increase in house prices according as people’s ability to pay more increases with larger loans. They would be in debt longer, and when the parents die, the bank gets the house instead of the children. Soon the banks will own half the country and the people nothing.
Whether or not my home loan interest rate scheme is not adopted, fixed interest loans should be made illegal, as this is a gamble. If inflation increases the borrower wins. If it decreases the bank wins. Gambling on such a massive scale is irresponsible. If banks wish to insure borrowers, what they should offer is to fix the real interest rate, and the real value of repayments. What should also be disallowed are innovative schemes to allow the borrower to borrow more, such as hundred year loans on houses. This inflates the price of houses, putting home ownership out of reach of more people. The net result is bank ownership of real estate rather than personal ownership. Low interest rates for the first year on a home loan, allow banks to attract new customers without putting any competitive pressure on them to reduce home loans for existing customers. This practice also should be disallowed.
Reducing interest rates will have two effects: Borrowers will want to borrow more; and lenders will want to lend less. Which effect would be greater I do not know.
Reducing personal interest rates would cause money to flow away from personal loans and into business. The greater money supply available commercially would, through competition among lenders, cause commercial interest rates to fall. They should not be regulated. As discussed previously, this would allow business to operate profitably with a lower gap between wages and prices, thus increasing real wages. And again, the wisdom of this way is that incentive is not destroyed in the process of creating greater equality.
Conventional wisdom says that economic problems are solved by increasing business profitability to increase investment. But reducing the profitability of lending for personal use achieves the same persion of funds to industry as increasing industrial profitability.
Regarding personal loans other than for homes I think that credit cards do far more harm than good. They encourage debt which diverts money from job creating investment. And they encourage people to live above their means until they get into financial difficulty, whereupon the interest they waste reduces the money they can usefully employ. Credit cards should be replaced by debit cards.
Debt on non-essential items should be discouraged. No one knows what the future holds. If circumstances change, difficulties may be created not only for the debtor, but for all those to whom he owes money, possibly causing bankruptcies and instabilities in the economy. It also seems morally wrong that people should be allowed to use their family home as security for the purchase of non-essential items. Anyway if interest rates and personal debts were reduced, people would have more money in their pockets, so that they would not need to borrow so much.
Some problems with my scheme have not yet been addressed, such as how to keep money in the country for home loans, when there may be more profit overseas. And how to prevent the rich from just renting out houses, instead of selling. These problems must be solved by someone with more financial understanding than myself. Perhaps there could be a requirement that a certain proportion of all investment go towards home loans.
I have show how I think it good to make good money from business interest rates but not from personal interest rates. I think that farm loans should be treated as somewhat between these two extremes.
As food is an essential item, excessive profits should not be made on its production, either by government through taxation, or by money lenders. I think that farm loans should be at a real interest rate of 3.5% with 2.5% going to the lender and 1% to the bank and nothing in tax to the government by either the banks or the lenders. Higher interest rates should only be to compensate the lenders and banks for the risk element. Where there is no risk, if the value of the farm as security exceeded the loan, the banks should only take 0.5% interest and the total real interest should be 3%.
Because the lender makes 2.5% interest, which is higher than the average interest rate for home loans, sufficient money should flow into agriculture to maintain adequate food production. But because this interest rate is lower than at present, farming costs would decrease and competition would maintain lower food prices.
Easing the financial burden upon farmers would enable them to practise sustainable agriculture. At present the only way that many farmers can pay the high interest on their loans is to take more out of the land than they put back. Land should be sold to them rather than leased, so that they will care for the soil.
I think it very unhealthy for farms to fall into the hands of the banks. If too few people own all the land, the lack of competition may drive up prices as in an old feudal system. If banks do get the land, it should only be for a maximum of twenty-five years, after which it reverts to its original owner.